2009 CCH Whole Ball of Tax
When You’re Left Holding the Bag, Tax Breaks May Ease the Pain
(RIVERWOODS, ILL. January 2010) – When a sick stock market, a bad economy or a shady operator leave your investments in shambles, the tax laws may offer some relief, according to CCH, a Wolters Kluwer business and a leading provider of tax, accounting and audit information, software and services (CCHGroup.com).
For those who’ve seen their investments in stocks and bonds wither, there is decidedly modest help. Taxpayers whose realized capital gains and losses net out to a loss can offset their ordinary income with up to $3,000 in losses, and carry any additional amount forward to future years.
“The key is that the losses must be realized – that is, the securities must actually be sold at a loss. A mere “paper” loss on a security you still hold doesn’t count,” said CCH Principal Federal Tax Analyst Mark Luscombe, JD, LLM, CPA. “Another caveat is that losses in a retirement account, such as an IRA or 401(k) generally can’t be used to reduce ordinary income.”
When Securities Become Worthless
In some cases, it’s impossible to sell securities to claim a loss because the securities have become worthless. When that’s the case, taxpayers can claim the loss as having occurred on the last day of the year in which the securities lost all value. It’s a logical way to handle the situation, but it can pose some difficulties.
First of all, the securities must truly have no value. Sometimes, a company will still trade – perhaps for pennies a share – even following a bankruptcy, so it would still have some value, and the shares must be sold before a loss can be claimed.
Second, the worthlessness has to be established by some identifiable event, such as a bankruptcy that totally wipes out shareholders’ value or by the company actually going out of business.
“The mere fact that you can’t find a buyer for your shares doesn’t mean that they’re worthless,” Luscombe said. “Some shares trade very infrequently, but the company may still be operating.”
Help for Victims of Ponzi Schemes
Some investors are left high and dry because their “investments” were never invested in the first place. In a classic Ponzi scheme, named after a man who perpetrated a gigantic fraud in the 1920s, investors are paid “earnings” out of the money that they, or new investors, have contributed, without any real profits having been realized.
“The schemes may look to be very attractive, and people who get in early enough may actually make money,” Luscombe observed. “In the end, though, they aren’t sustainable.”
The most notorious recent Ponzi scheme was run by Bernie Madoff, who was sentenced to prison in 2009 for running a “wealth management” business that defrauded thousands of investors of billions of dollars.
And the Madoff scheme wasn’t an isolated incident. More than 150 Ponzi schemes came to light in 2009.
“These schemes often collapse when the economy turns sour and people seek to cash in their investments, only to find that the cupboard is bare,” Luscombe said.
Losses in fraudulent investment schemes receive special treatment under the tax laws. They are treated as theft losses, rather than ordinary investment losses, so they are not limited to offsetting only $3,000 of ordinary income. What’s more, they are not subject to the ordinary limitations on casualty and theft losses, which have a $500 floor in 2009 and are deductible only to the extent that they exceed 10 percent of adjusted gross income.
The amount of the loss equals the amount invested less any “profits” or “earnings” received and any recovery victims have made or are likely to make. The loss can also include any income taxes previously paid on “earnings.” Victims are allowed to claim the loss in the year in which a “reasonable taxpayer” discovers the fraud. If the loss produces a net operating loss (NOL) for the year, it can be carried back and forward under NOL rules.
“Taxpayers also have the option of amending prior year returns to reflect their losses in those years, but since only tax returns for the last three years can be amended, this is unlikely to produce a more favorable result,” Luscombe noted.
Small Business Stock Is Special
Special rules govern sales of the stock of small businesses described in Section 1244 of the Internal Revenue Code. Although gains are treated as capital gains, losses of up to $50,000 are treated as ordinary losses and can offset an equivalent amount of ordinary income. They’re reported on Form 4797. Losses in excess of $50,000 are reported as capital losses on Schedule D.
“The rules are designed to encourage investment in small businesses – those with a paid-in capital of $1 million or less at the time the stock is issued,” Luscombe said. “There can be a high failure rate with such enterprises, and this provision for writing off losses is some compensation.”
About CCH, a Wolters Kluwer business
CCH, a Wolters Kluwer business (CCHGroup.com) is a leading provider of tax, accounting and audit information, software and services. It has served tax, accounting and business professionals since 1913. CCH is based in Riverwoods, Ill. Wolters Kluwer is a leading global information services and publishing company. Wolters Kluwer is headquartered in Alphen aan den Rijn, the Netherlands (www.wolterskluwer.com).
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